Option contract

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An option contract, or simply option, is defined as "a promise which meets the requirements for the formation of a contract and limits the promisor's power to revoke an offer". [1] Option contracts are common in professional sports.

Contents

An option contract is a type of contract that protects an offeree from an offeror's ability to revoke their offer to engage in a contract.

Under the common law, consideration for the option contract is required as it is still a form of contract, cf. Restatement (Second) of Contracts § 87(1). Typically, an offeree can provide consideration for the option contract by paying money for the contract or by providing value in some other form such as by rendering other performance or forbearance. Courts will generally try to find consideration if there are any grounds for doing so. [2] See consideration for more information. The Uniform Commercial Code (UCC) has eliminated a need for consideration for firm offers between merchants in some limited circumstances. [3]

Introduction

An option is the right to convey a piece of property. The person granting the option is called the optionor [4] (or more usually, the grantor) and the person who has the benefit of the option is called the optionee (or more usually, the beneficiary).

Because options amount to dispositions of future property, in common law countries they are normally subject to the rule against perpetuities and must be exercised within the time limits prescribed by law.

In relation to certain types of asset (principally land), in many countries an option must be registered in order to be binding on a third party.

Application of option contract in unilateral contracts

The option contract provides an important role in unilateral contracts. In unilateral contracts, the promisor seeks acceptance by performance from the promisee. In this scenario, the classical contract view was that a contract was not formed until the performance that the promisor seeks was completely performed. This was because the consideration for the contract was the performance of the promisee. Once the promisee performed completely, consideration was satisfied and a contract was formed and only the promisor was bound to his promise.

A problem arose with unilateral contracts because of the late formation of the contract. With classical unilateral contracts, a promisor can revoke his offer for the contract at any point prior to the promisee's complete performance. So, if a promisee provides 99% of the performance sought, the promisor could then revoke without any remedy for the promisee. The promisor had maximum protection and the promisee had maximum risk in this scenario.

The modern view of how option contracts apply now provides some security to the promisee in the above scenario. [5] Essentially, once a promisee begins performance, an option contract is implicitly created between the promisor and the promisee. The promisor impliedly promises not to revoke the offer and the promisee impliedly promises to furnish complete performance, but as the name suggests, the promisee still retains the "option" of not completing performance. The consideration for this option contract is discussed in comment d of the above cited section. Basically, the consideration is provided by the promisee's beginning of performance.

Case law differs from jurisdiction to jurisdiction, but an option contract can either be implicitly created instantaneously at the beginning of performance (the Restatement view) or after some "substantial performance". Cook v. Coldwell Banker/Frank Laiben Realty Co., 967 S.W.2d 654 (Mo. App. 1998).

It has been hypothesized that option contracts could help allow free market roads to be constructed without resorting to eminent domain, as the road company could make option contracts with many landowners, and eventually consummate the purchase of parcels comprising the contiguous route needed to build the road. [6]

Assignability

It is a general principle of contract law that an offer cannot be assigned by the recipient of the offer to another party. However, an option contract can be sold (unless it provides otherwise), allowing the buyer of the option to step into the shoes of the original offeree and accept the offer to which the option pertains. [7]

Contract theory

In economics, option contracts play an important role in the field of contract theory. In particular, Oliver Hart (1995, p. 90) has shown that option contracts can mitigate the hold-up problem (an underinvestment problem that occurs when the exact level of investment cannot be contractually specified). [8] However, there is a debate in contract theory whether option contracts are still useful when the contractual parties cannot rule out future renegotiations. [9] As has been pointed out by Tirole (1999), this debate is at the center of the discussions about the foundations of the incomplete contracts theory. [10] In a laboratory experiment, Hoppe and Schmitz (2011) have confirmed that non-renegotiable option contracts can indeed solve the hold-up problem. [11] Moreover, it turns out that option contracts are still useful even when renegotiation cannot be ruled out. The latter observation can be explained by Hart and Moore’s (2008) idea that an important role of contracts is to serve as reference points. [12]

See also

Related Research Articles

Consideration under American law Concept in common law as applied in the US

Consideration is the central concept in the common law of contracts and is required, in most cases, for a contract to be enforceable. Consideration is the price one pays for another's promise. It can take a number of forms: money, property, a promise, the doing of an act, or even refraining from doing an act. In broad terms, if one agrees to do something he was not otherwise legally obligated to do, it may be said that he has given consideration. For example, Jack agrees to sell his car to Jill for $100. Jill's payment of $100 is the consideration for Jack's promise to give Jill the car, and Jack's promise to give Jill the car is consideration for Jill's payment of $100.

From a legal point of view, a contract is an institutional arrangement for the way in which resources flow, which defines the various relationships between the parties to a transaction or limits the rights and obligations of the parties.

<i>Carlill v Carbolic Smoke Ball Co</i>

Carlill v Carbolic Smoke Ball Company [1892] EWCA Civ 1 is an English contract law decision by the Court of Appeal, which held an advertisement containing certain terms to get a reward constituted a binding unilateral offer that could be accepted by anyone who performed its terms. It is notable for its curious subject matter and how the influential judges developed the law in inventive ways. Carlill is frequently discussed as an introductory contract case, and may often be the first legal case a law student studies in the law of contract.

Illusory promise

In contract law, an illusory promise is one that courts will not enforce. This is in contrast with a contract, which is a promise that courts will enforce. A promise may be illusory for a number of reasons. In common law countries this usually results from failure or lack of consideration.

Consideration is an English common law concept within the law of contract, and is a necessity for simple contracts. The concept of consideration has been adopted by other common law jurisdictions, including the US.

In economics, the hold-up problem is central to the theory of incomplete contracts, and shows the difficulty in writing complete contracts. A hold-up problem arises when two factors are present:

  1. Parties to a future transaction must make noncontractible relationship-specific investments before the transaction takes place.
  2. The specific form of the optimal transaction cannot be determined with certainty beforehand.
Posting rule

The posting rule is an exception to the general rule of contract law in common law countries that acceptance of an offer takes place when communicated. Under the posting rule, that acceptance takes effect when a letter is posted. In plain English, the "meeting of the minds" necessary to contract formation occurs at the exact moment word of acceptance is sent via post by the person accepting it, rather than when that acceptance is received by the person who offered the contract.

Third-party beneficiary

A third-party beneficiary, in the law of contracts, is a person who may have the right to sue on a contract, despite not having originally been an active party to the contract. This right, known as a ius quaesitum tertio, arises when the third party is the intended beneficiary of the contract, as opposed to a mere incidental beneficiary. It vests when the third party relies on or assents to the relationship, and gives the third party the right to sue either the promisor or the promisee of the contract, depending on the circumstances under which the relationship was created.

Offer and acceptance Two components of agreement

Offer and acceptance are generally recognised as essential requirements for the formation of a contract, and analysis of their operation is a traditional approach in contract law. The offer and acceptance formula, developed in the 19th century, identifies a moment of formation when the parties are of one mind. This classical approach to contract formation has been modified by developments in the law of estoppel, misleading conduct, misrepresentation, unjust enrichment, and power of acceptance.

Nudum pactum in Latin literally means 'naked promise' or 'bare promise'. In common law, it refers to a promise that is not legally enforceable for want of consideration. An example of a nudum pactum would be an offer to sell something without a corresponding offer of value in exchange. While the offer may bind a person morally, since the offer has not been created with any consideration, it is gratuitous and treated as a unilateral contract. The offer is therefore revocable at any time by the offeror before acceptance by the offeree.

At common law, substantial performance is an alternative principle to the perfect tender rule. It allows a court to imply a term that allows a partial or substantially similar performance to stand in for the performance specified in the contract.

<i>Hamer v. Sidway</i> 1891 New York contract law case

Hamer v. Sidway, 124 N.Y. 538, 27 N.E. 256, was a noted decision by the New York Court of Appeals, New York, United States. Hamer v. Sidway is an important case in American contract law which established that forbearance of legal rights on promises of future benefit made by other parties can constitute valid consideration, and, in addition, that unilateral contracts were valid under New York law.

Consideration Concept of legal value in connection with contracts

Consideration is a concept of English common law and is a necessity for simple contracts but not for special contracts. The concept has been adopted by other common law jurisdictions.

Contract Legally binding document establishing rights and duties between parties

A contract is a legally enforceable agreement that creates, defines, and governs mutual rights and obligations among its parties. A contract typically involves the transfer of goods, services, money, or a promise to transfer any of those at a future date. In the event of a breach of contract, the injured party may seek judicial remedies such as damages or rescission. Contract law, the field of the law of obligations concerned with contracts, is based on the principle that agreements must be honoured.

<i>Daulia Ltd v Four Millbank Nominees Ltd</i>

Daulia Ltd v Four Millbank Nominees Ltd [1977] is an English contract law case, concerning unilateral contracts, and when embarking on the performance of an act for which an offer is open, at what point the offer may be withdrawn. In particular, Goff LJ observed that there would be a duty to not prevent full performance of terms in a unilateral offer, once performance had begun.

Indian Contract Act, 1872 Contract Act

The Indian Contract Act, 1872 prescribes the law relating to contracts in India and is the key act regulating Indian contract law. The Act is based on the principles of English Common Law. It is applicable to all the states of India. It determines the circumstances in which promises made by the parties to a contract shall be legally binding. Under Section 2(h), the Indian Contract Act defines a contract as an agreement which is enforceable by law.

United States contract law

Contract law regulates the obligations established by agreement, whether express or implied, between private parties in the United States. The law of contracts varies from state to state; there is nationwide federal contract law in certain areas, such as contracts entered into pursuant to Federal Reclamation Law.

Contracts (Rights of Third Parties) Act 1999 United Kingdom legislation

The Contracts Act 1999 is an Act of the Parliament of the United Kingdom that significantly reformed the common law doctrine of privity and "thereby [removed] one of the most universally disliked and criticised blots on the legal landscape". The second rule of the doctrine of privity, that a third party could not enforce a contract for which he had not provided consideration, had been widely criticised by lawyers, academics and members of the judiciary. Proposals for reform via an act of Parliament were first made in 1937 by the Law Revision Committee in their Sixth Interim Report. No further action was taken by the government until the 1990s, when the Law Commission proposed a new draft bill in 1991, and presented their final report in 1996. The bill was introduced to the House of Lords in December 1998, and moved to the House of Commons on 14 June 1999. It received royal assent on 11 November 1999, coming into force immediately as the Contracts Act 1999.

In economic theory, the field of contract theory can be subdivided in the theory of complete contracts and the theory of incomplete contracts.

Power of acceptance Concept in contract law

Power of acceptance is a concept of contract law. It refers to the power vested in the offeree by the offeror through the offer being made. It is used to determine whether the acceptance of an offer is valid.

References

  1. ↑ Restatement (Second) of Contracts § 25 (1981)
  2. ↑ "Examples and Explanations for Contracts, 7e", Brian Blum, 2017 p. 104 [p. 109 in PDF version]. Wolters Kluwer.
  3. ↑ "Uniform Commercial Code - § 2-205. Firm Offers". Cornell University Law School, Legal Information Institute.
  4. ↑ "Optionor".
  5. ↑ See § 45 of Restatement (Second) of Contracts for the black letter law of the option contract's application to this situation.
  6. ↑ Benson, Bruce L. (2006). "Do Holdout Problems Justify Compulsory Right-of-Way Purchase". Street Smart: Competition, Entrepreneurship, and the Future of Roads. p. 65.
  7. ↑ John D. Calamari, Joseph M. Perillo, The Law of Contracts (1998), p. 707.
  8. ↑ Hart, Oliver (1995). Firms, contracts, and financial structure. Clarendon Press.
  9. ↑ Lyon, T. P.; Rasmusen, E. (2004). "Buyer-Option Contracts Restored: Renegotiation, Inefficient Threats, and the Hold-Up Problem" (PDF). Journal of Law, Economics, and Organization. 20 (1): 148–169. doi:10.1093/jleo/ewh027. ISSN   8756-6222.
  10. ↑ Tirole, Jean (1999). "Incomplete Contracts: Where do We Stand?". Econometrica. 67 (4): 741–781. CiteSeerX   10.1.1.465.9450 . doi:10.1111/1468-0262.00052. ISSN   1468-0262.
  11. ↑ Hoppe, Eva I.; Schmitz, Patrick W. (2011). "Can contracts solve the hold-up problem? Experimental evidence". Games and Economic Behavior. 73 (1): 186–199. doi:10.1016/j.geb.2010.12.002. S2CID   7430522.
  12. ↑ Hart, Oliver; Moore, John (2008). "Contracts as Reference Points*". Quarterly Journal of Economics. 123 (1): 1–48. CiteSeerX   10.1.1.486.3894 . doi:10.1162/qjec.2008.123.1.1. ISSN   0033-5533.
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